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The Intuitive Case for ESG

As the quantifiable metrics of environmental, social, and governance (ESG) performance of public companies become ever more plentiful, structured, and timely, many investors are asking an important question: “why should I care?”

Often, the premise behind this skeptical question is the underlying belief that the increasing focus on ESG is a perception that this is a marketing fad that will fade over time, as much of what is being touted by ESG advocates feels subjective, intangible, and unproven as a meaningful factor in investment analysis. Such skepticism on ESG links to the belief that “doing good” comes at the expense of efficiency and profit – that businesses should sacrifice their duty to shareholders for the sake of an arbitrary value system.

In reality, these ESG metrics are actually new factors for investors on how they could make more money, lower risk and have more resilient portfolios. In 2015, more than 4,500 companies report ESG data and metrics – tracked by Morgan Stanley spin-off MSCI, Inc. (MSCI) ; Sustainalytics, a new partner of Morningstar, Inc. (MORN) , European firm Oekom, IW Financial; and our ESG ratings firm HIP Investor.

ESG factors, covering metrics from customer satisfaction to employee engagement to water efficiency to Board diversity are all meaningful metrics for investment analysis – as they all have a Return on Investment (ROI) profile. This ROI profile is more positive than assumed, and increasingly tied to business competitive advantage and resiliency. While environmental, social, and governance factors have always been a part of business, the forces of ubiquitous communications, global markets, information/knowledge transparency, natural resource depletion, and societal attitudes are converging in a way as never before. This creates structural changes to the economy that all business must adapt to…or risk becoming uncompetitive.

Consider, for example, the case of multinational athletic footwear and apparel manufacturer Nike Inc. (NKE) , whose partnerships with suppliers and contractors that abused their workers in the early 1990s led to high profile protests, including at the 1992 Barcelona Olympic Games. By the mid-1990s, activists were targeting Nike’s celebrity endorsers – basketball legend Michael Jordan and television celebrity Kathy Lee Gifford. The latter’s career was so impacted that some have referred to the fallout as the beginning of Corporate Social Responsibility (CSR). By 1997, college students nationwide, including at Nike’s home state of Oregon were protesting the company, and its stock price began drastically underperforming major market indices despite a booming general economy. Finally, in 1998, then CEO Phil Knight addressed the issue with a series of real reforms, stating publicly: “I truly believe the American consumer doesn’t want to buy products made under abusive conditions.”

Today, rather than the 20th century practice of hiding information about its vendors and supply chain, Nike makes available the full list of all factories they work with directly on its website – which is more in line with 21st century demands for transparency. President Ronald Reagan’s strategic advice to “Trust but Verify” is becoming more prevalent in capital markets via ESG factors. Even so, students, investigative journalists, activists, and consumers continue their vigilance on Nike, even with the tens of millions of dollars invested annually on CSR initiatives by Nike.

At Nike, the company’s troubles with the “social” pillar of ESG was much more than a public relations nuisance; it had a dramatic and long term negative impact on the company’s sales, brand image, cost structure, and stock price – all things that matter very much to investors and other stakeholders.

In the 20th century, even if consumers were against buying products made by abused workers, it would be too easy for a company to keep that information a secret. In the digital age of the 21st century, anyone with basic investigative skills and an internet-connected device, possibly with a smartphone video camera, can upload to YouTube or Twitter, Inc. (TWTR) what they discover. Any unethical supply chains can immediately be the subject of an organized public relations campaigns, an online campaign like change.org, or a group protests against unethical behaviors.

Socially responsible supply chains are fast becoming a source of competitive advantage. Consumers favor and are more inclined to buy an ethically made product. Unilever says that sustainably oriented products are growing at double-digit revenue-growth rates. Products that do not rate highly on ESG risk lower growth and possibly higher costs from ESG factors like unhappy supply chain workers.

Other instances of how ESG affects business performance/risk and thus shareholder value include:

Companies with more ethnic and gender diverse workforces, managers, and board members are more likely to be emphatic to the needs of a diverse, global customer base, and thus be better at servicing them. A 2011 report by Deloitte Consulting made the case for diversity as a source for innovation and competitiveness by quantifying the growing share of total purchasing power by ethnic minorities in the United States, and the rise of the tech-savvy, brand loyal, affluent, and early adopter LGBT community.

From Deloitte Review: Diversity as an Engine of Innovation

Companies that are more efficient in their use of natural resources are more capital efficient, and less exposed to environmental regulation risk. Corporate Knights Capital, a Toronto, Canada based clean capitalism investment advisor, is finalizing the development of a cloud-based tool that allows investors to compare the past performance of any given portfolio with a “cleaned” version that strips out the least environmentally efficient companies.

Fortunately, it is becoming increasingly more possible to access reliable, timely, and structured data on ESG factors. Companies are disclosing, whether voluntarily or because of regulation: the ratio of CEO to workforce pay; the amount of water and energy used in operations; the amount of greenhouse gas emissions from operations, customers and suppliers; the gender ratio of its workforce; similar details of their supply chains; and more.

In other words, ESG is becoming increasingly quantifiable and measurable, and thus, because it also ties to revenue growth, cost positions, return on investment and risk exposure, it is very useful in investment analysis.

ESG is no different than any other fundamental factor when considering a business’ potential and risks. The “feel good” marketing cachet may be transitory, but ESG is of fundamental importance to investors, regardless of how it’s branded, and is now here to stay. That’s why all investors, advisers, fund managers and retirement plan fiduciaries should care.

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